As a general rule, borrowing from your 401(k) is a bad idea. At best, you have probably reduced your retirement funds. At worst, you could default on your loan and send yourself into a debt spiral, while also increasing your current tax burden.
Still, there are times when borrowing from a 401(k) is necessary, or at least perceived to be so – and according to a recent study by TIAA-CREF, a significant number of Americans have done just that. Almost one-third of us have taken out a loan from our retirement plan. Of those who have taken out loans on 401(k) plans, 43% have taken out at least two.
Why do we do it? The primary reason given was to pay off debt, according to 46% of respondents (52% of the women responding and 41% of the men). An emergency expenditure was the next most likely reason at 35% (40% of men versus 29% of women). The other four causes listed were home purchase or renovation (26%), covering bills due to a lost job (24%), education costs for themselves or children (20%), and special events such as weddings or vacations (15%).
Generally, you can borrow half of your retirement plan balance, up to a $50,000 limit. 9% of poll respondents borrowed up to that 50% limit, with 47% borrowing at least 20% of their savings.
How do you decide if a 401(k) loan is the best for your situation?
The Director of Personal Finance for Morningstar, Christine Benz, suggested asking yourself four questions before securing a loan against your 401(k). We elaborate on those points a bit.
- Will you get a higher rate of return than if you left the money alone? Unless you are paying off high-interest rate credit card debt, the answer is probably no. A rising market makes that even less likely.
This may not matter to you if you are investing in a home where you will build equity, or you have an emergency medical bill or similar priority expense.
- Is your retirement plan still on track? This is important, because if you are borrowing against a 401(k), you are also likely to further derail your retirement plan by contributing less to your account while your loan is outstanding. 57% of the respondents in the TIAA-CREF poll did so, with 81% of those respondents between 18-34 years old.
- Is your job secure? If you lose your job before you pay back the 401(k) loan, you will have to pay off the loan in a lump sum, which could force you into default.
- Can you realistically pay the loan back? Terms for the loan often require that payments begin during your next pay period, and often through an automatic paycheck deduction. Factor this in when calculating the first point above.
We would add a 5th point – what alternatives are available? For example, there are so many other methods of paying for your child’s college that a 401(k) loan should be far down the list. Paying off high-interest credit card debt may be a good use because of the limited alternatives – assuming you can curb the habits that got you into the problem in the first place.
Are there any advantages to borrowing against a 401(k)? The primary one is convenience, as credit checks are not necessary and cash can be in hand shortly. In addition, fees are often lower than typical loans and the usually are no early payment penalties. However, those advantages are slim compared to the risks involved.
Explore every other reasonable option to avoid borrowing against your 401(k) – but if you must, make sure that you repay the loan as promptly as possible.
Winnie Sun is a registered representative with, and securities offered
through LPL Financial, member FINRA/SIPC. Investment advice offered through Sun Group Wealth Partners, a
registered investment advisor and a separate entity from LPL Financial.
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